Do Tax Cuts Stimulate the Economy?

Last update July 2012

It seems self-evident that tax-cuts should stimulate the economy. It
seems so self-evident, that we discuss the theory as if it were a known
fact. We don't even question the claim. But history offers us some evidence
that tax cuts don't stimulate the economy.

In 1921 & 1925, major taxes cut were passed. In the following
years a stock market bubble formed while working class wages stagnated,
then in 1929 the bubble burst and the economy crashed into the Great
Depression.

In 1981 a tax cut was passed. The economy sank deeper into recession
and stayed in recession for nearly two years.

In 1987 major tax cuts were passed. By 1990 growth declined leading
into the 1991 recession.

In 2001 a tax cut was passed, and another rebate was given in 2008.
From 2001 through 2008 the economy grew slower than it did in the preceding
8 years while a bubble formed in stocks, housing, and executive salaries.
In 2008 the bubble burst, and now the economy in sinking into the worst
recession since the Great Depression.

So what do we see in the data overall? Perhaps we should look at the
data more thoroughly. We start by looking at the marginal tax rate on
the richest citizens.

When we look at the tax rate charged to the richest
citizens, we see that low taxes correlate to slow growth. When marginal
taxes on the rich were below 40% growth remained below 4.5%. When
top taxes were above 65% growth tended to be higher, even going above
6%. Historically, higher taxes on the rich have correlated to higher
growth.

Making the comparison:

Max Tax below 40%

Max Tax above 65%

Average Growth

3.0%

3.5%

25 percentile

2.5%

2.0%

75 percentile

4.0%

5.7%

Maximum Growth

4.5%

8.7%

Overall, higher taxes on the rich historically have correlated to
higher economic growth for the country. It's counterintuitive, but
it is the historical fact. Just, to be certain, we can compare taxes
to job creation also.

Again we see higher growth when the marginal tax
on the rich is higher. It might seen odd, but that's what history
shows us.

Let's look closer at how the economy changed after tax cuts. We
can look at how both GDP and employment grew just before the tax
cut, and then just after the tax cut. Did they grow faster or slower?

Year of tax cut

GDP growth

Employment growth

before

after

change

before

after

change

1964

4.6%

5.7%

+1.1

No

Data

In the last 50 years there were 5
tax cuts to the rich. Three of them were followed by a decline
in GDP growth, 3 were followed by a decline in employment growth.
The evidence suggests that tax cuts do not promote growth and
probably promote decline.

1971

2.9%

2.6%

-0.3

0.6%

2.3%

+1.7

1981

2.8%

3.5%

+0.7

1.8%

.1.4%

-0.4

1987

3.7%

2.3%

-1.4

2.6%

1.1%

-1.5

2001

3.3%

2.7%

-0.6

1.2%

-0.4%

-1.6

Typical change

-0.25%

-0.6%

Year of tax increase

before

after

before

after

In the last 50 years there was just
one tax increase to the rich. After that tax increase both the
GDP and employment growth rates increased significantly.

1993

1.9%

3.7%

+1.7%

0.8%

2.5%

+1.7%

The historical evidence suggests that an economic decline will
follow a tax cut to the rich, and economic growth may follow a tax
increase to the rich. The evidence suggests that the optimum tax
marginal tax rate on the rich is higher than 60%.

Can we make similar conclusions for taxes rates on the middle class
and poor?

For the lower classes, the historical data does not
have an apparent pattern. The scatter is wide and fails to show a
tendency in either direction.

Historically, taxes on the middle class and poor have shown no correlation
to economic growth. Other factors must have greater influence than tax
rates.